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January 7, 2020
To the friends and clients of the Harvey Investment Company:
The S&P 500 jumped 31.5% in 2019. Coupled with last year’s -4.4%, the two year S&P 500 return is 12.1%. This result is modestly above the annualized five year return of 11.7%. The annualized 10 year return is 13.5%. These are indeed salad days for equity investors.
Bond markets don’t get near the hype the stock market does. Nevertheless, the returns for the astute fixed income investor who bought bonds for appreciation, not for income and safety, have been spectacular. Interest rates on the 30 year US Treasury topped 14% in 1981. In August they fell below 2%, capping a forty year bull market. Both the markets for stocks and bonds soared in 2019. Financial markets are, an over caffeinated market analyst might declare, en fuego.
Maintaining realistic expectations for future returns is a challenge for all but the dyed in the wool skeptic. A place to start is recalling the Greek philosopher Heraclitus’s aphorism “no man steps in the same river twice.” This dictum may be interpreted many ways depending on one’s circumstances. To us, it as an admonition on the dangers inherent in confusing extrapolation with analysis.
It is hard to overstate the effect feelings of certainty can play in determining asset values. As an example, the average homebuyer prices his or her bid for a home in great part on the mortgage rate he or she expects to pay. While the most important consideration in the purchase is usually the desirability of the home as a place to live, the buyer is also likely to consider the question, “Is this a good investment?” Among other factors, the answer must include an estimate of future mortgage rates and the level of certainty that accompanies that expectation.
And so it is with all investments. How will future conditions compare with today’s? If one anticipates change, how sure can one be of one’s assumptions? Just as familiarity with a physical space breeds confidence in one’s movements, stability in the investment space breeds a similar assurance. Investor confidence, in our experience, often morphs into unjustified certainty leading to all manner of careless reasoning. Therein lies the perilous nature of today’s financial markets.
For ten years running now inflation has tracked between 1% and 2%. Interest rates, marching a step or two behind, have settled at historically low levels, a boon to the borrower and penalty for the thrifty. The US economy has logged the longest running recession free business recovery in history. GDP growth has reliably progressed at a modest 2% to 3%---- just enough for businesses to improve their margins, but not enough to stir inflation. These investment inputs have exhibited stability for such an extended period that many investors take them as givens despite the innumerable, powerful forces that act on them.
This is nirvana for investors and business executives. They lay plans confident that the variables that mean most to them---inflation, interest rates, and demand growth---are locked in place. Many investors give little credence to the possibility that this comfortable structure could break down. They are oblivious to the distinction between acting confidently and acting with the hubris of certainty---- oblivious, too, of the cost that distinction, if unrecognized, may exact.
An example of confusing confidence with certainty was painfully clear in the aftermath of the great banking crisis of 2008 and 2009. Leading up to the crisis there was a widespread sense of certainty that home prices could only go up. Speculation in the housing market became rampant. Normally conservative individuals turned lines of credit secured by their homes into virtual ATM machines. The financial havoc wreaked by this behavior and by the proliferation of mortgage backed securities need not be recounted. The ‘’back to earth” shattering of misplaced certainty can be destructive indeed, as we saw a decade ago.
We have high aspirations for growing your assets. A big part of achieving those goals is avoiding foolish errors. Risk often hides in plain sight, obscured by a cloak of respectability conferred by conventional wisdom. We constantly frame and reframe the assumptions that underpin markets’ valuation structures, knowing that each year brings altered conditions and a new set of challenges. One never steps in the same river twice.
We thank you for the continuing confidence you show in us. You may be certain that we will work hard every day to make sure that confidence is well placed.
Sincerely,Samuel C. Harvey